Steve Landsburg on the efficiency wage as a theory of involuntary unemployment


The fair-wage effort hypothesis is a theory of mass low-skilled unemployment


Living wage advocates make much of the demoralising effects of pay inequality on workplace productivity. In common with the efficiency wage hypothesis, this is another example of what Nozick (1974) called normative sociology; the study of what the causes of social problems ought to be. Again, living wage activists misconstrue what the fair-wage effort hypothesis was seeking to explain.

The fair-wage effort hypothesis aimed to fill gaps in the efficiency wage hypothesis by explaining why unemployment is so much higher among the lower skilled (Akerlof and Yellen 1988, 1990). Under the fair-wage effort hypothesis, workers slack off if paid less than they think they deserve:

The motivation for the fair wage-effort hypothesis is a simple observation concerning human behavior: when people do not get what they deserve, they try to get even (Akerlof and Yellen 1990, p. 256).

Lazear (1989, 1991) contends that employers too may want greater pay equity to temper over-competitiveness in teams. If pay and promotions in a team are linked to the relative performance of its members, large pay differentials may undermine co-operation and might encourage sabotage:

Very large pay spreads induce high effort, but they also create a work environment in the firm that is not very pleasant… individuals who are competing with one another can either seek to outperform others, or they can contribute to the failure of others. Such incentives can result in collusion (Dye, 1984) or in sabotage (Lazear, 1989). Thus, pay structure must strike a balance between providing incentives for effort and reducing the adverse consequences associated with this kind of industrial politics (Lazear and Shaw 2007, p. 95).

Lazear’s (1989, 1991) theory about the industrial politics arising from pay inequality stressed how sizable rewards to individual members of a team could lead to a lack of team play and lower team output. If the prizes were smaller for superior relative performance, the pay rise after a promotion or the annual performance bonus, there may be more teamwork (Lazear 1989, 1991). Akerlof and Yellen (1990) were correct in their insight that their hypothesis about fair-wage effort applies more to workers on lower wages with fewer chances of moving up promotion ladders and pay scales.

The fair-wage effort hypothesis is but another Keynesian macroeconomic theory of unemployment:

The hypothesis explains the existence of unemployment. Unemployment occurs when the fair wage w* exceeds the market-clearing wage. With natural specifications of the determination of w*, this hypothesis may explain why skill and unemployment are negatively correlated. In addition, it potentially explains wage differentials and labor market segmentation (Akerlof and Yellen 1990, p. 256).

The fair-wage effort hypothesis was developed as a descendant of the efficiency wage hypothesis because the latter cannot explain why wages are high for everyone working in high-paid industries:

All workers in better-paid industries tend to receive positive wage premia. That is, the wages of secretaries and engineers are highly correlated across industries. Ease of supervision and the magnitude of turnover costs might well be correlated across industries for a given occupation explaining, for example, why, say, skilled machinery operators receive positive wage premia in most industries. But there is no obvious reason why, say, secretaries, should be harder to supervise in the chemical industry where pay is high, than in the apparel industry where pay is low (Akerlof and Yellen 1988, p. 44).

The efficiency wage hypothesis also offered “no natural explanation” for why unemployment rates [JC1] are much higher among the lower-skilled (Akerlof and Yellen 1990). Skilled workers are probably more difficult to monitor than the unskilled so their unemployment rates should be higher than for the low-skilled as a worker discipline device but the contrary is the case (Akerlof and Yellen 1990).

The fair-wage effort hypothesis aimed to fill gaps in the efficiency wage theory of unemployment by explaining why low skilled unemployment is much higher both in recessions and in better times. Living wage activists must accept that their demands for workplace pay equity increase low-skilled unemployment under a Keynesian theory which they embrace with considerable enthusiasm.

If high wages are paid to the more skilled to attract the best applicants, demands for pay equity by their less skilled co-workers could price some of them out of the market leading to unemployment (Akerlof and Yellen 1988, 1990). In addition, pay equity norms are unlikely to respond quickly enough to fluctuations in aggregate demand so wages can be too high in recessions causing mass unemployment of the low skilled (Akerlof and Yellen 1988, 1990; Summers 1988). The unemployed cannot successfully offer to work for less than existing workers do in a recession because they cannot make a credible commitment to eschew fairness considerations once hired (Akerlof 2002).

An important premise of New Keynesian macroeconomics is demands for pay equity come at a price. At a price that is high enough for the efficiency wage and fair-wage effort hypotheses to be put as a comprehensive New Keynesian explanations of involuntary mass unemployment (Gordon 1990).

Both the efficiency wage hypothesis and the fair-wage effort hypothesis are attempts to flesh out a theory of extensive labour market dysfunction leading to mass unemployment. Living wage activists are using Keynesian theories of why wages are too high to argue for even higher wages.

An efficiency wage is a theory of persistent mass unemployment


Shapiro and Stiglitz (1984) first put forward their theory of an efficiency wage to explain large-scale involuntary unemployment. It was the very real threat of a prolonged spell of unemployment (rather than a morale boosting pay rise) that motivated employees to put in more effort to keep their jobs:

To induce the worker not too shirk, the firm attempts to pay more the “going rate”; then, if the worker is caught shirking and is fired, he will pay a penalty. If it pays one firm to raise its wage, it pays all firms to raise their wages. When they all raise their wages, the incentive to shirk again disappears. But as all firms raise their wages, the demand for labour decreases, and unemployment results. With unemployment, even if all firms pay the same wage, a worker has an incentive not to shirk. For, if he is fired, an individual will not immediately obtain another job. The equilibrium unemployment rate must be sufficiently large that it pays the workers to work rather than take the risk of being caught shirking (Shapiro and Stiglitz 1984, p. 435).

The unemployed offer to work for less pay than existing employees but they are not hired because their labour productivity is not assured at this lower pay (Akerlof 1982, 1984; Katz 1986, 1988; Yellen 1984). There is involuntary mass unemployment because of the prevalence of efficiency wages:

If there is involuntary unemployment in an equilibrium situation, it must be that firms, for some reason or other, wish to pay more than the market-clearing wage. And that is the heart of any efficiency-wage theory (Akerlof 1984, p. 79).

Direct parallels were quickly drawn between the efficiency wage hypothesis as a worker discipline device eliciting greater effort and the old Marxist concept of the reserve army of the unemployed:

… it pays each firm to increase its wage to eliminate shirking. When all firms do this, the average wage rises and employment is reduced. In equilibrium, all firms pay a wage above the market clearing level, creating unemployment. Since jobs are scarce and rationed, the loss of a job can involve a lengthy spell of unemployment. The reserve army of the unemployed acts as a discipline device making shirking costly (Katz 1986, pp. 240-41).

It is misconceived for living wage activists to use a theory of lengthy unemployment to justify a large living wage rise but argue that there will be little unemployment because of the efficiency wage effects. This is the exact opposite of what the efficiency wage hypothesis is about. The leading Keynesian macroeconomists of their generation were striving to explain mass unemployment:

… the economists who developed the theory of efficiency wages (including Shapiro and Stiglitz, Akerlof and Yellen and Yellen) had no illusions that they were helping business firms to discover a new way to increase profits. The economists who developed efficiency wage theory were trying to explain persistent unemployment. Hence the title of Janet Yellen’s famous survey, Efficiency Wage Models of Unemployment.

The question that motivated efficiency wage theory was not why firms should raise wages but why firms don’t cut wages when they should. The answer they gave was that firms don’t cut wages despite unemployment because they fear that workers will respond to lower wages with reduced productivity …

In the original efficiency wage literature, there is no wishful thinking–no idea that we can have more of everything that we want without trade-offs. Instead of being desirable, the efficiency wage is a problem because lower wages would reduce unemployment and be better for the economy … the efficiency wage theorists took it for granted that to the extent that firms can increase profits by raising wages they have already done so (hence the persistent unemployment) (Tabarrok 2015).

Gordon was blunt about why efficiency wage arguments were popular and with whom

If any development in the microeconomics of labor markets could be called the “rage of the 80s,” it is efficiency wage theory, based on the hypothesis that worker productivity depends on the level of the real wage. When there is such a link between the wage rate and worker efficiency, firms may rationally pay a real wage rate that exceeds the market-clearing level. Firms may refuse to reduce the wage to hire members of a pool of unemployed workers who may be available at a lower wage, fearful that a reduction in real wages for existing workers may reduce productivity by more than the gain in lower wages (Gordon 1990, p. 1157).

Living wage activists have it the wrong way around about the social benefits of paying an efficiency wage. The efficiency wage hypothesis is a theory of why wages are too high and employment is too low (Akerlof 1982, 1984, 2002; Yellen 1984; Katz 1986, 1988; Stiglitz 2002). Living wage activists are using a well-respected theory of why wages are too high to argue that wages are too low.

How to argue against employment protection laws while arguing for additional employment regulation

The Centre for American Progress recently published an excellent survey of the costs to employers of hiring and training new recruits. As the paper notes:

it is costly to replace workers because of the productivity losses when someone leaves a job, the costs of hiring and training a new employee, and the slower productivity until the new employee gets up to speed in their new job.

Our analysis reviews 30 case studies in 11 research papers published between 1992 and 2007 that provide estimates of the cost of turnover, finding that businesses spend about one-fifth of an employee’s annual salary to replace that worker.

The purpose of the research published by the Centre for American Progress was to argue there were large costs to employers from replacing even low paid workers and there are a workplace policies such as paid family leave and workplace flexibility will reduce these job turnover costs to employers.


Similar arguments are used to justify a living wage on efficiency grade wage grounds. A living wage would reduce job turnover and therefore the costs to employers of job turnover in the jobs.

The research published by the Centre for American Progress also illustrates the bargaining power of workers. Employers who failed to treat workers fairly and pay them the going wage risk an increase in job quit rates. These large costs of job turnover have been carefully documented by the Centre for American Progress.

Employers incur fixed costs of employment when they recruit and train new employees. These recruits must be expected to stay long enough to work sufficient hours for the firm to expect to recover these investments (Oi (1962, 1983a, 1990), Idson and Oi (1999), Hutchens (2010), Hutchens and Grace-Martin (2006)).

These costs are fixed costs because they do not vary with how many hours the employee works or with how long an employee stays with their employer. These fixed employment costs must be recouped over the expected job tenure of the employee with the firm. Employers will not hire an additional worker unless they anticipate recovering the costs of doing do including fixed employment costs and other overheads.

Central to arguments such as by Richard Epstein for employment at will is the threat of the employee to quit imposes a real cost on employers which the employer will seek to avoid by treating their employees well.

The best way to prevent exploitation of workers is to make hiring and firing easy, facilitate new entry by firms into all markets and promote full employment – a worker with other available job opportunities is difficult to exploit.

With large fixed costs of recruitment and training, employers cannot afford to behave whimsically if they wish to survive in competition with the rival firms with more competitive wage and employment policies.

By the same token, the large fixed costs of employment documented by the Centre for American Progress illustrate the large investments employers must risk to recruit a new employee.

If this large investment in recruitment doesn’t turn out well, but is difficult to get out of because of strict employment laws, employers will be more reluctant in the first instance to risk this investment because they are risking several months wages in fixed costs of employment. As Richard Epstein explained:

A second great advantage of the at-will system is that it supplies an informal method of bonding that keeps both sides in line.

The employer who tries to take advantage of the employee by altering working conditions for the worse will be met by the threat to quit, for now the deal is worth less to the employee than the wage received.

So long as markets are competitive the switching costs will be relatively low – lower in fact than they are in a highly regulated world where employers have to think twice before taking on a worker whom they may be unable to fire if things do not work out.

Yet on the other side, the employee who takes it easy on the job is faced with dismissal because he is no longer worth his wages.

But even here management will hesitate to dismiss for good reasons. One is the very substantial costs of recruiting and training a replacement who might or might not turn out to be better than the worker who was dismissed. The second is that unjust dismissals could induce other workers to leave while the going is good, thereby compounding the problem of recruitment and retention.

The Centre for American Progress was good enough to document the very substantial costs of recruiting and training a replacement employee. As the Centre for American Progress explained in their paper, employers have every reason to protect their investments in training and recruitment by minimising job turnover costs.

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